Thursday, June 7, 2012

Mr.
Bernanke's recent comments before the Congressional Joint Economic Committee on
June 7th brought up the subject of Europe and its debt crisis. Here is a
quote from his testimony:

"Nevertheless,
the situation in Europe poses significant risks to the U.S. financial system
and economy and must be monitored closely. As always, the Federal Reserve
remains prepared to take action as needed to protect the U.S. financial system
and economy in the event that financial stresses escalate."

That
is an interesting comment in light of what I'm about to post. Can central bankers really help in this situation?

A
paper entitled "Propping Up Europe" written by Jean Pisani-Ferry
and Guntram B. Wolff and released by Bruegel, the Brussels-based think-tank, takes an interesting look
at how the Bank of England, the Federal Reserve and the European Central
Bank have responded to the crisis that basically had its genesis in the early
days of the Great Recession. As you will see, the exceptional response
has led to a massive and unprecedented increase in the balance sheets of all
three central banks with results that are modest at best.

Since
2007, the Federal Reserve, the Bank of England and the ECB have undertaken a
series of initiatives that were intended to ward off the Depression bogeyman. Both
Ben Bernanke and Mervyn King have used quantitative easing in an attempt to
stimulate the economy in the face of what was essentially zero interest rates. In
contrast, the ECB took a sharply different approach since they were reluctant
to purchase huge volumes of government bonds as you will see later.

Here
are two graphs that show the composition of each banks’ balance sheets,
providing evidence that the Fed and the Bank of England have both embarked on
massive purchases of government bonds(shaded in red), bloating their balance sheets with
domestic government paper:

In
the case of the Bank of England, effective March 29th, 2012, they
are now the holders of nearly £304 billion worth of gilts as shown on this
chart:

This
works out to roughly one-third of the entire stock of the UK government debt of
just over £1 trillion. At the end of February 2012, the purchase of gilts
accounted for 116 percent of the increase in the Banks' balance sheet over the
five-year period from February 2007.

In
the case of the Federal Reserve, they have become the purchaser of last resort
of U.S. Treasuries; as net purchases by the private and foreign sector have
dropped off as shown here, the Fed has stepped in to pick up
the slack. Purchases of government bonds by the Fed accounted for 103
percent of the increase in the overall size of its balance sheet since February
2007.

The
result of these actions by both central banks has been elevated levels of
unemployment, a housing market that is far from healthy and economic growth
that is modest at best and moribund at worst. Surely, this is not particularly the resounding success that
Mr. King and Mr. Bernanke had hoped for when they undertook their experiment,
is it? Oh yes, and let's not forget near zero interest rates on savings and pension plan investments as an added benefit.

In
sharp contrast, the European Central Bank (ECB) has relied on lending to
financial institutions (the three year bank refinancing or LTRO) with
repurchase agreements of collateral, commonly known as "repos" in
financial circles, as shown on this graph (with repos shaded in beige):

LTRO
is an attempt by the ECB to get banks lending again and to push interest rates
down by providing abundant liquidity at fire sale prices, particularly in the
most troubled nations. Liquidity received by the banks through the LTRO
carries a one percent interest rate. The use of this massive intervention
by the ECB has resulted in Europe's banking system parking their money at the
ECB in record amounts as shown on this graph:

Basically,
Europe's banking system is hoarding the ECB's cash injection by keeping it
parked in overnight deposits at the Bank, despite the fact that deposits only
receive a 0.25 percent interest rate, lower than the 1 percent interest cost of
the LTRO liquidity. That tells us a lot about the state of Europe's
banking system, doesn't it?

Here
is a graph showing how several European nations have availed themselves of this
once-in-a-lifetime opportunity:

Notice
that prior to mid 2010, German banks were the primary users of the ECB
liquidity. As the crisis has continued, the banking systems in the most
troubled nations of Spain, Portugal, Italy, Ireland and Greece have availed
themselves of the ECB's largesse as Germany’s demands have waned.

The
authors of the paper question whether these actions, particularly LTRO, have
been effective. They note that:

"…the low-cost three-year loans offered by the ECB should
be seen by market operators as helpful for restoring the soundness of the
banking system and thereby boosting bank stocks."

Here
is a graph showing the stock market price indices for the banking systems in
seven European nations with the LTRO events highlighted:

Oops! Apparently,
the ECB's actions may have helped ensure the funding of banks, but, as we have
seen in recent days and weeks, the banks still have questionable solvency, most
recently in Spain but even Germany's banks are suffering under the stress.

Since the whole point of the exercise by all of these
central banks was to stabilize the global financial system, it would appear
that we can uncategorically state that, while the system has not yet imploded,
the world's key central bankers should hardly be patting themselves on the back
for a job well done. Rather, it appears that their desperate attempts may
well have just postponed the inevitable. While Mr. Bernanke assures us
that he is there to protect the system, his arsenal, and those of his fellow
central bankers, has proven to be rather ineffective four years into this
seemingly never-ending crisis no matter what remedial approach is taken.

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About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.